After the recent redemption pressures witnessed by Fixed Maturity Plans, the product clearly needs to be revamped and repositioned. As Sebi deliberates on new norms for these products, we asked experts what needs to be done, and their views on some of the reform ideas being mooted
At present the Securities and Exchange Board of India (Sebi), the market regulator, is deliberating on new norms for debt funds. What has made these reforms imperative is the heavy redemption pressure that fixed maturity plans (FMPs) and liquid funds witnessed in recent months, which led to a sharp outflow of funds from these categories. The massive decline has raised concerns about the health of the industry. While one player, Lotus India Mutual Fund, has already been taken over by Religare (a predominantly debt fund player, Lotus threw in the towel after the redemption episode), a few others are said to be in a precarious position.

What happened
When you invest in an FMP, the fund manager in turn invests the money in other debt instruments. In recent times, doubts had developed over the quality of some of these investments, like Commercial Papers (CPs) issued by corporates. It was feared that to garner higher returns many fund managers had overlooked credit quality. Fearing defaults by some of the issuers (especially real estate companies and non-banking financial companies) as the liquidity crunch within the Indian financial system mounted, a few large corporate investors pressed for redemption.

Now, the secondary market for debt paper, is quite illiquid. When the funds tried to sell these papers, they found it difficult to find buyers for them, and so had to sell them at a discount. This caused the net asset value (NAV) of their funds to plunge. When other large investors saw this happening ? NAVs of FMPs and liquid funds normally do not fall sharply ? they too got worried. Then all hell broke loose with a large number of investors stampeding to exit these funds. This set off a vicious cycle of asset sales, declining NAVs, and more redemption pressure.

What can be done
With the Reserve Bank of India (RBI) opening a special repo window for banks to lend to mutual funds (a move that provided much-needed liquidity to these cash-starved funds), the redemption pressure has ebbed now. But clearly, Sebi does not want a recurrence of this episode and hence would like to plug the regulatory and structural loopholes in these products. It has invited suggestions from players in the mutual fund industry, including the Association of Mutual Funds of India (Amfi), and is expected to come out with new norms for FMPs and liquid funds very soon. Meanwhile, we asked experts what changes they think need to be made to FMPs, and for their views on some of the reform ideas being mooted.

Announce indicative portfolio and indicative yield? Before launching a new fund offer (NFO) for an FMP, a fund house first sees what debt paper is available at that point of time. It amalgamates these papers into a portfolio, calculates what yield they will provide, deducts the fund house?s expenses, and arrives at an indicative yield for the FMP. This is the yield promised to investors at the time of launch.

One suggestion doing the rounds is that fund houses should not announce an indicative portfolio or an indicative yield. The reason: one, when funds announce ?indicative? yields, buyers treat them as guaranteed returns. And two, this practice sets off competition among funds to announce a higher yield (to attract more customers). And since you can?t earn a higher yield without taking on higher risk, fund managers then invest in paper having poor credit quality.
As for indicative portfolios, the argument is: don?t tie fund managers down to a single portfolio announced in advance. Allow them to change it during the tenure of the fund, as happens in the case of other funds.

But most financial planners and investment advisors we spoke to felt that doing away with the indicative portfolio was not a good idea from the investor?s point of view. ?If investors or their financial planners can?t look at the portfolio in advance, how will they take a call on what the payout will be, and the quality of the investment?? enquires Kolkata-based mutual fund analyst Prasunjit Mukherjee. Adds Pune-based financial planner Veer Sardesai: ?If you don?t announce an indicative portfolio, investors will not be able to gauge the risk and the return of the product. And if they feel that they don?t have adequate information, they may shy away from this product.?

Make disclosure of actual portfolio mandatory. Lahar Bhasin, head of research at ICRA Online, which undertakes rating of mutual funds, suggests that disclosure of the ?actual? portfolio of FMPs (after their launch) should be made mandatory. ?This will boost investor confidence,? she says. Adds Sardesai: ?We need mutual funds to stick to the bonds in their indicative portfolios so that the investor is assured of the quality of the underlying debt.?

In practice, sticking to the indicative portfolio can be difficult, as Uma Shashikant, managing director, Centre for Investment Education and Learning, points out. ?The fund will be able to get the interest rate that has been promised only if it can invest the amount it indicated. So it is indicative portfolio and indicative yield for an indicative collection amount for the FMP. If an FMP mobilises much lower than the target amount, it may not get the indicative yield, or sometimes, the bond itself.?
Raise the exit load to 6 per cent. Another idea that is on the cards to prevent large-scale redemption is raising the exit load of FMPs up to 6 per cent (from the current maximum of 3 per cent).

A high exit load, it is argued, will deter investors who wish to exit during the tenure of the FMP. Concurs Bhasin: ?Exit barriers are a must.? Adds Mukherjee: ?Those investors who want to redeem mid-course will then not invest in FMPs and will instead go for liquid funds.?
But the flip side to reducing liquidity is that it will make FMPs less attractive to investors.

Sardesai believes that raising the exit load alone will not suffice. ?If investors believe that credit quality of the underlying investment is in doubt and that the mutual fund may end up losing a part of its capital, they will withdraw funds, irrespective of the exit load, once they believe that their principal is at risk.? According to him, the foremost problem that needs to be addressed is one of fund houses investing in poor-quality paper.

List on the bourses. Another idea being mooted so that fund houses don?t bear the brunt of redemption pressure is that FMPs be listed on the stock exchange. The question here is whether there will be many takers for listed FMPs. Says Bhasin: ?In the Indian context, the listing option has so far met with only a moderate response with trading volumes remaining poor.? Moreover, as Sardesai says: ?Listing involves a cost that will eat into the returns of these funds.? FMPs operate on very thin margins. ?There is no way a product with a .05 -0.07 per cent margin will bear a 0.75-1 per cent listing fee. Listing an FMP is, therefore, not feasible,? says Shashikant.
Reduce maturity mismatch. Maturity mismatch means that while the FMP has one tenure, the paper it has invested in has another, usually longer, tenure. It is being suggested that funds should restrict the mismatch to 10 per cent of the portfolio.

Portfolio mismatches occurs for two reasons. One, fund managers invest in longer-duration paper for their higher yield. And in a falling interest-rate scenario, these papers see higher price appreciation (than shorter-duration paper), so fund managers sometimes try to make speculative gains on them. But the liquidity of longer duration paper is also lower, which creates a problem in case of high redemption pressure and at the end of the tenure (if the fund hasn?t been able to dispose of these papers).
Two, maturity mismatch occurs because paper of a matching duration is just not available. Explains Sardesai: ?Funds can either hold cash till such an instrument comes along or use an existing instrument of varying maturity. It will be difficult for funds to contain the mismatch entirely.?
From the investor?s point of view, containing the maturity mismatch would be a positive development, as it would lead to lesser volatility and steadier returns when the FMP is held to maturity.
?Duration matching can be done only at the portfolio level. It would be cumbersome to look at matching duration of each security to the maturity of the FMP. So the 10 per cent recommendation is sensible from a practical point of view,? says Shashikant.

The bottomline
If the regulator wishes to avoid a recurrence of the recent redemption episode, it must ensure the following. First, there must be greater oversight to ensure fund houses maintain the credit quality of their portfolio, and stick to their indicative portfolios much more closely than is presently the practice. This will ensure that investors don?t doubt the credit quality of their portfolios ? which triggered the redemption pressure in the first place. ?If sticking to the indicative portfolio is difficult, then funds need to commit to a credit quality standard, or seek rating,? says Shashikant.

Two, investors can?t have both higher yields and higher liquidity. Says Shashikant: ?If the portfolio needs to be always liquid, then yield has to be sacrificed. Products need to be positioned indicating the trade-off between liquidity and yield clearly.? Clearly, mid-course exit by investors needs to be discouraged by putting in place a higher exit load.

Finally, investors too need to learn that merely chasing returns is not a sound investment practice; they also need to pay heed to risk. Before investing in an FMP that offers a higher indicative yield, the investor should look at the portfolio of the fund and assess its risk profile, or get his financial planner to do so. After all, in the financial world there are no free lunches and higher return is always accompanied by higher risk.

What needs to be done
Ensure credit quality of FMP portfolio
Reposition products
Investors who want higher liquidity should invest in liquid funds
Those who want higher yield should go for FMPs
Discourage mid-course redemptions with higher exit load